Tax timing

Want to avoid the AMT? Make sure you time your financial decisions right

SAN FRANCISCO (MarketWatch) -- Ask a tax professional how to avoid the alternative minimum tax and the odds are high you'll hear "multiyear planning." Even now, taxpayers "ought to be sketching out 2007 and even 2008," said Greg Rosica, a tax partner at Ernst & Young and contributing editor to the Ernst & Young Tax Guide.

Making reasonable guesses now will allow you to run "what if?" scenarios. Only then can you make the right decisions about the timing of key financial transactions throughout the year, Rosica said.

After all, "timing is everything when it comes to staying out of the alternative minimum tax," said Mark Nash, a Dallas-based partner in the private company services practice of PricewaterhouseCoopers.

"You look at your income and change your timing of it. You look at deductions and change the timing of those. You look at preference items -- incentive stock options for instance -- and change the timing of when you pull the trigger on those options," he said.

"Sometimes there's a limit to what you can do," he said, but planning ahead means "you know what opportunities to look for."

Others agreed. "It's time-consuming and potentially expensive," said John Nersesian, managing director of wealth management services for Chicago-based Nuveen Investments. "But you've go to crunch the numbers to measure the impact of many of these financial decisions [including] the recognition of capital gains or losses, charitable contributions, retirement plan distributions or contributions."

For most people, it doesn't matter whether they pay the AMT or regular tax -- as long as their bill is as low as possible. The AMT may look appealing, with its top tax rate of 28% (the lower rate of 26% applies to income up to $175,000 over the AMT exemption amount; the higher rate kicks in on income above $175,000 over the exemption amount).

Taxpayers may well wonder, "28% versus 35% ... why is AMT a bad deal?" Nersesian said. First, more income is subject to the AMT's 28% rate because many regular deductions don't count in the AMT. Second, the regular tax code is progressive, so your first few dollars of income are taxed at lower rates. "Even though it rises to 35%, my effective rate is much lower," Nersesian said. "Under the AMT, dollar one is taxed at 26%."

Are you in the AMT?

The first thing to do is assess whether you'll fall into the AMT. That means figuring out now what your tax situation is likely to be over the course of the year.

If you don't use a professional tax preparer, tax-preparation software can help. For instance, TurboTax's "planning" tab lets you enter up to four different scenarios, so you can play around with the numbers -- increasing your income or deductions, for instance -- to see how your decisions in the year ahead may push you into the AMT.

There are some rules of thumb about who falls into the AMT. For instance, the Ernst & Young Tax Guide 2007 says if your regular taxable income is $100,000, and as a married-filing-jointly taxpayer you claim more than $32,225 in "preference" items, you're likely to trigger the AMT. (The guide's analysis assumes no capital gains or qualifying dividends.)

Preference items are deductions and other tax perks not counted in the AMT, including state and local taxes, personal exemptions, miscellaneous itemized deductions, and the standard deduction.

A married-filing-jointly taxpayer with $75,000 in regular taxable income and more than $33,187 in preference items also likely triggers AMT, as does a single filer with $75,000 in regular income and more than $26,472 in preference items, according to the guide. Same goes for a married-filing-jointly taxpayer with $200,000 in regular taxable income and more than $21,419 in preference items; for a single taxpayer with that income, the trigger is $16,765 in preference items.

Another rule: If you keep your income under the current AMT exemption amount -- right now it's $62,550 for those married and filing jointly and $42,500 for single filers but it usually changes annually -- you won't be subject to the AMT. Still, "most people are not willing to give up income," Nash said.

Also, for taxpayers with income above $1 million or so, "there's a lower probability that their affected by AMT than taxpayers in the $200,000 or $300,000 range," Nersesian said. "Once I report really, really high levels of income, more of my income is now being subject to the 35% rate which increases the probability that the regular code produces a higher bill." Taxpayers pay the higher of the regular tax or the AMT.

Rethink financial decisions

When considering how to avoid the AMT, you'll need to assess financial moves carefully.

"Every financial transaction has a consequence," Nersesian said. "An executive in San Francisco who's holding some stock options: Should they exercise them this year? How many? They've got to re-run the numbers."

Exercising incentive stock options and then holding until long-term capital gains tax rates kick in -- usually a smart move under the regular tax system -- may ramp up your income and push you into the AMT because the difference in the initial price and the fair market value is income for AMT purposes.

"Your innocent attempt to book a capital gain in your portfolio could very well be the trigger that subjects you to alternative minimum tax," Nersesian said. Capital gains and dividends are subject to the same 15% rate in the regular tax code and AMT, he said, "but when you generate your capital gain, you raise your adjusted gross income." That may affect the degree to which you can enjoy the AMT exemption amount, which reduces the amount of income subject to the alternative minimum tax. For 2006, it's $62,550 for those married filing jointly. But that exemption phases out above $150,000 in income and disappears at $400,000.

Meanwhile, he said, taxpayers whose adjusted gross income is about $400,000 are likely to be in the AMT. Those taxpayers may want to accelerate income. If you've got a source of income -- an unexercised incentive stock option, a bonus check -- "I may choose to take it in that taxable year because the marginal rate at which it'll be taxed under the AMT is 28%."

Then, consider retirement-plan withdrawals. "Say I'm 71 years old, I live in San Francisco, I've got a big IRA worth $1 million. I'm going to have to take that money out at some point," Nersesian said. "Maybe the best approach is to take it out this year, while it's subject to the 28% rate, whereas in future years it might be subject to 35%," he said. "There are no standardized planning strategies."

Reverse strategy

Taxpayers who know they'll be paying the AMT should accelerate income into the current tax year, and delay deductions into the next tax year if possible.

"If I am subject to the AMT this year, there is no benefit in prepaying my state property taxes, no benefit in prepaying my state income taxes, no benefit in accelerating my other deductions," Nersesian said.

With state income taxes, taxpayers can "minimize how much gets paid in during the year," Rosica said. "That might subject them to an underpayment penalty ... but you might easily find that paying that is much smaller than what the impact of alternative minimum tax will be on you."

Then, if your tax situation leaves you back in the regular income tax next year, those deductions will help reduce your bill.

And, remember, if you're in the AMT this year, consider bringing as much income as possible into this year, Nersesian said. "Given the top tax rate of 28%, I may be better off accepting that income and having it taxed at a lower marginal rate."

Also, review your portfolio. "Take a look at your fixed-income allocations," Nersesian said. "Am I better off in municipal debt or taxable debt? If I'm in the AMT, the marginal tax rate is 28%, so I've got to recrunch the numbers to see. I may be better off in taxable debt."

Don't forget about private-activity municipal bonds, he said. Many taxpayers are surprised to find that income is taxable under the AMT.

More extreme measures

"If you're in a high-tax state, it becomes much more difficult" to maneuver out of the AMT, said Tom Riley, a certified public accountant with Beard Miller Company LLP, in Syracuse, N.Y., and president of the New York State Society of Certified Public Accountants.

"In a place like New York City, we have high property taxes, high income taxes, city taxes. That makes it very, very difficult," he said.

For some taxpayers, it might even make sense to move. "If you're a retiree ... it could make a difference" -- potentially lowering your tax bill significantly, Riley said. But you need to consider all taxes levied by the other state, including state income tax, city taxes, and property taxes.

"I'm not seeing a lot of people willing to take that radical of a step," Nash said. "The AMT is calculated on an every year basis, and your income situation could change," Nash said.

"Since the AMT is a moving target every year, I'm not seeing anybody want to load up their wagons."

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